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Chapter 4
THE ECONOMIC ENVIRONMENTS FACING BUSINESSES
OBJECTIVES
4-1 Explain the value of economic analysis
4-2 Differentiate the types of economic environments
4-3 Explain the idea of economic freedom
4-4 Differentiate the types of economic systems
4-5 Interpret indicators of economic development, performance, and potential
4-6 Profile elements of economic analysis
CHAPTER OVERVIEW
When companies source, manufacture, and/or market products in foreign countries, they
encounter fascinating and often challenging economic environments. Chapter Four first explores
the economic environments of countries in which an MNE might want to operate by discussing
the importance of economic analysis and identifying the major dimensions of that process. It
then compares and contrasts key macroeconomic indicators, such as economic growth, inflation,
and the surpluses and deficits reflected in the balance of payments. Finally, it reviews the
characteristics of the major types of economic systems, explores the principles of economic
freedom, and concludes by highlighting the connection of the conceptual anchor of this chapter,
economic freedom, to meta-measures of the vitality of developed, developing, and emerging
economies.
CHAPTER OUTLINE
OPENING CASE: EMERGING ECONOMIES: COMEBACK OR COLLAPSE [see
Figure 4.1]
Despite far-ranging opinions, most agree that the ongoing integration of national economies into
the global market has changed economic aspects of the business environment. Some
commentators see trends that indicate a flattening of the world, where others emphasize the entry
of billions of people into the global marketplace from China, India, and the former Soviet
countries. These developments and trends will powerfully impact one’s job, company, future, and
even one’s country. The global economic meltdown impacts the business environment in many
ways, including an increase in trade barriers and risk aversion. As the global economy improves,
many see this as an inflection point and realize that the need to understand the economic impacts
on the global business environment is more important than ever. Studies predict a shift from the
rich and powerful countries of the twentieth century to many emerging economies in greater
Asia. This shift can be seen as we track the global economic output. [see Fig 4.1] All of these
changes represent opportunities and threats for global players in the new economy.
I. INTERNATIONAL ECONOMIC ANALYSIS
In the IB realm, cultural, political, and legal systems influence a company’s decision on
where, when, and how to do business. This chapter completes our profile of the
environmental domains of IB, evaluating how economic systems shape a market. Studying
an economic environment helps managers make better investment choices and operating
decisions. Resource constraints require managers to identify which countries in the world
warrant investment as well as those they must avoid.
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Various principles help managers better assess economic environments, including:
1. System Complexity. Economic environments are dynamic systems. The intricacy of the
simplest economic system defies straightforward specification. Stipulating models that
definitively represent a country’s economic performance and potential as well as work
reliably in all types of economic environments is difficult.
2. Market Dynamism. Market changes can make today’s valid measures dubious
tomorrow. Evolving circumstances, compounded by disruptive situations and puzzling
trends, generate anomalies and exceptions that convert comebacks into collapses.
3. Market Interdependence. Just as no one is an island, no country is isolated. The
consequence of cross-national connections means actions here influence outcomes there.
A. Navigating Challenges
Figure 4.2 shows how managers navigate these challenges.
II. WHO’S WHO IN THE GLOBAL BUSINESS ENVIRONMENT
In IB, the development level of a country is the single most important indicator of who’s
who. It influences nearly every aspect of business, including the nature of consumer
demand, organization of productive activity, attitudes toward foreign investors, regulatory
transparency, sophistication of market systems, and the freedom one has to make effective
and efficient business decisions. Hence, estimating the attractiveness of a country as a place
to do business and, once there, making smart investment and operational decisions depends
on how well managers understand its economic environment.
A. Developed Economies. Developed economies generally have high-income levels,
extensive industrialization, advanced technological infrastructure, and high standard of
living. Developed economies steadily shift to diversified, service-oriented activities that
rely on information and technology to support product and process innovation.
Manufacturers in developed economies have outsourced many activities to low-cost
factories in the emerging economies.
B. Developing Economies. Developing economies generally have low-income levels, slight
industrialization, incomplete infrastructure, and lower standards of living. Significant gaps
exist in economic and social characteristics between developed and developing
economies. Some argue that developing countries have strong communities and social
ties, extraordinary self-sufficiency, and admirable work ethics. Alternatively, one regularly
finds higher infant mortality, shorter life expectancy, lower literacy levels, poorer public
hygiene, insufficient health care, and inadequate nutrition in developing countries relative
to their developed counterparts.
C. Economies in Transition/Emerging Economies. At the high end of developing
economies, we find faster growing, quickly industrializing countries such as China,
Mexico, Indonesia, and the Philippines. Increasingly, these countries are referred to as
economies in transition, emerging markets, frontier markets, or newly industrializing
countries; generally, description defaults to emerging economies. Emerging economies are
experiencing accelerating growth in productivity, manufacturing, exporting, and per capita
income, resulting in material improvements achieved in years, rather than decades. Their
financial systems, political institutions, and market infrastructure steadily modernize.
Market liberalization promotes foreign investments and growing exports, deregulation and
privatization improve business efficiency, and expanding economic freedoms encourage
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entrepreneurialism. Prosperity and progress support a growing middle class, whose
economic aspirations fuel a revolution of rising expectations, thereby spurring society and
the state to improve living standards. When one speaks of the emerging economies, many
point to Brazil, Russia, India, and China (referred to as the BRICs) [see Map 4.1.]
D. The Issue of Different Degrees of Development.
Different reasons explain different levels of economic development in different countries.
Analysis directs attention to the economic, political/legal, and cultural moderators of
development. [see Table 4.2.].
III. ECONOMIC FREEDOM [see Map 4.2.].
Economic freedom holds that one has the right to work, produce, consume, save, and
invest in the way that one prefers. It measures the absence of government coercion or
constraint on the production, distribution, or consumption of goods and services beyond the
extent necessary for citizens to protect and maintain liberty. The Economic Freedom Index
estimates economic freedom in a particular nation. In principle, this index measures the
degree that a nation accepts Adam Smith’s thesis that “basic institutions that protect the
liberty of individuals to pursue their own economic interests result in greater prosperity for
the larger society.” The ultimate score ranges from zero (no freedom) to 100 (full freedom);
hence, the higher the index for a particular nation, the higher its degree of economic
freedom. Determining factors include: property rights, freedom from corruption, fiscal
freedom, government spending, labor freedom, business freedom, monetary freedom, trade
freedom, investment freedom, and financial freedom. Countries ranking highest on this
index tend to enjoy both the highest standards of living as well as the greatest degree of
political freedom. Paradoxically, despite the documented benefits of economic freedom, just
5 countries, out of 178, have policies that maximize it. The surge in state capitalism helps
explain why many emerging and developing economies deemphasize economic freedom.
LOOKING TO THE FUTURE__State Capitalism: Detour or Destination?
The impressive performance in many countries with emerging and developing economies
suggests that free market economics is no longer the only viable route to modernization. Many
see China as the bellwether; it has used state capitalism to develop and direct the world’s
fastest-growing economy that, in turn, has powered the swiftest, most extensive rise out of
poverty any nation has ever seen. Throughout Asia, the Middle East, Africa, and Latin America,
authoritarian governments emulate China’s model. Some dismiss state capitalism as inevitably
unacceptable.
IV. TYPES OF ECONOMIC SYSTEMS
An economic system is the set of structures and processes that guide the allocation of scarce
resources and shapes the conduct of business activities in a nation. The spectrum of systems
is anchored on one end by capitalism and on the other by communism. Free-market
(capitalistic) economies are built upon the private ownership and control of the factors of
production, while communism is based on state ownership of economic activity.
A. The Market Economy. A market economy describes the system where individuals,
rather than government, make the majority of economic decisions. Key factors include
consumer sovereignty, the freedom of market entry and exit, and the determination of
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prices according to the laws of supply and demand. Credited to Adam Smith, the
laissez-faire principle, i.e., nonintervention by government in a country’s economic
activity, states that producers are driven by the profit motive, while consumers determine
the relationship between price and quantity demanded. Thus, scarce resources are
allocated efficiently and effectively. The high standards imposed by a market economy
are based on some preconditions. Four of these preconditions indicate a basis for
consistent growth: sound macroeconomic policies and solid macroeconomic background,
fair and transparent political institutions, open trade, and high levels of education.
B. The Command Economy. Also known as centrally planned economies, command
economies are built upon the government ownership and control of the factors of
production. Central planning authorities determine what products will be produced in
what quantities and the prices at which they will be sold. Most often, the totalitarian aims
of communism gave the highest priority to industrial investments and military spending at
enormous expense to the consumer sector.
C. Mixed Economy. Mixed economies fall between the extremes of market and command
economies. While economic decisions are largely market driven and ownership is largely
private, government nonetheless intervenes in many economic decisions. The extent and
nature of such intervention may take the form of government ownership of certain factors
of production, the granting of subsidies, the taxation of certain economic activities, and/or
the redistribution of income and wealth.
V. ASSESSING ECONOMIC DEVELOPMENT, PERFORMANCE, AND POTENTIAL
Managers use different economic measures to assess a country’s level of performance and
potential. In practice, generally, managers begin an analysis by looking at the monetary
value of the total flow of goods and services in the economy of a nation.
A. Monetary Measures
1. Gross National Income (GNI) measures the value of all production in the
domestic economy together with the income that the country receives from other
countries (in the forms of profits, interest, and dividends), less the same sorts of
payments that it has made to other countries. Among monetary aggregates, GNI
provides the broadest measure of economic performance.
2. Gross Domestic Product (GDP) is the total market value of goods and services
produced by workers and capital within a nation’s borders; it provides the truest
measure of national economic activity. Technically, GDP plus the income generated
from exports, imports, and the international activities of a nation’s companies equal
its GNI.
3. Gross National Product (GNP) is the total value of all final goods and services
produced within a nation in a particular year.
B. Improving Economic Analytics
GNI, GDP, and GNP estimate an economy’s absolute performance. Despite strengths, they
can distort country comparisons. Managers improve the economic indicators by adjusting
for the (1) growth rate of the economy, (2) number of people in a country, and (3) local cost
of living.
a. Rate of Economic Growth. Monetary aggregates take a static snapshot of an
economy at a point in time. Hence, they do not capture its rate of change.
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Interpreting present and forecasting future performance prompts considering an
economy’s growth rate.
c. Population Size. Managers routinely adjust indicators by the number of people
who live in a country. Adjusting GNI by population, therefore, lets managers
qualify a country’s performance for its demographics. A larger population base
provides the opportunity for greater productivity, but can also create additional
challenges for an economy. An analyst must review the population size and
determine GNI per capita to establish a true picture of a nation’s standard of living.
d. Purchasing Power Parity. While exchange rates define the number of units of one
currency that are required to purchase one unit of another currency, they do not
determine what a unit of currency can buy in its home country, i.e., exchange rates
do not incorporate differences in the cost of living. Purchasing power parity
(PPP) represents the number of units of a country’s currency required to buy the
same amount of goods and services in the domestic market that one unit of income
would buy in another country. PPP is estimated by calculating the value of a
universal “basket” of goods that can be purchased with one unit of a country’s
currency. [see Map 4.3.].
C. The Wildcard: The Shadow Economy
Sometimes called the black, gray, or parallel market, or the informal economy, the shadow
economy includes the extra-legal activities (e.g., driving an unlicensed taxi, street trading, or
unregistered day care center) as well as well as illegal doings (e.g., prostitution,
drug-slinging, illicit gambling, cigarette and alcohol smuggling, product piracy) that fall
beyond official statistics. All countries experience the effects of the shadow economy; they
are particularly influential in developing economies. Some countries are moving to include
shadow activities when measuring production in their economy.
D. Sustainability and Stability
Sustainability and stability perspectives hold that the objective of economic activity is to
create an environment for people to enjoy long, healthy, and happy lives.
1. Sustainability. Green economics holds that an economy is a component of, and
dependent on, the natural world. Green measures gauge economic performance in
terms of the effect of current choices on long-term sustainability. Estimators of
economic progress toward improving happiness includes:
a. Net National Product (NNP) measures the depletion of natural resources
and degradation of the environment that result from making and consuming
products
b. Genuine Progress Indicators (GPI) begin by applying the same accounting
framework used to calculate GDP. It then adjusts for the corresponding costs
of reduced environmental quality, health and hygiene, livelihood security,
equity, free time, and educational attainment.
c. Human Development Index (HDI). Estimating a country’s degree of
human development, in terms of the physical, intellectual, and social
standards that shape its overall quality of life, helps managers measure
market potential. The UN translates this view into the HDI and its
components: Longevity, measured by life expectancy at birth; Knowledge,
measured by the adult literacy rate and the combined primary, secondary,
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and tertiary gross enrollment ratio; and Standard of Living, measured by
GNI per capita (PPP).
2. Stability. Universal affluence, despite its appeal, is presently impossible. Rather
than assessing an economy’s potential for increasing affluence, perspectives like
happynomics or welfare economics encourage incorporating elements of
psychology, health, security, and sociology. More fundamentally, they advocate
redefining the traditional performance standards of wealth, income, or profit to
reflect principles of well-being, quality of life, and life satisfaction. Estimators of
economic progress toward improving happiness include:
a. Your Better Life Index (YBLI): Developed by the Organization for
Economic Cooperation and Development (OECD), the YBLI advocates
evaluating economic performance in terms of matters that people worldwide
believe are important (e.g., housing, jobs, social relationships, health,
security, work–family balance, education) but that fall beyond the narrow
scope of monetary measures.
b. Gross National Wellness Index (GNWI): GNWI measures a country’s
capacity to promote individual well-being in terms of mental, health, work,
income, social relations, economic, retirement, political, and environmental
standards.
c. Happy Planet Index (HPI): The HPI holds that the fundamental logic of
monetary metrics are misaligned, overly emphasizing growth at all costs
while downplaying its costly, destabilizing, and often destructive
externalities. In the realm of the HPI, progress is defined not in terms of
economic development, but through success in achieving a sustainable
well-being for all.
POINT—COUNTERPOINT: Growth: Positive and Productive
POINT: Many people believe growth is not only good but it is necessary for our continued
existence as an individual, a company, and even as a society. They argue that the benefits of
growth include moral stability, reduction in poverty, business and government prosperity,
improved potential for a peaceful and environmentally friendly world, and a very human benefit
of a better and longer life.
COUNTERPOINT: Others believe that although growth has its benefits, you cannot discount the
costs. These costs are short and long term and include inevitable economic inequalities,
misleading benefits of growth, and the impact on sustainability and individuality. Finally, they
posit that the current rate of growth is not possibly sustainable.
VI. ELEMENTS OF ECONOMIC ANALYSIS
A. Integrating Economic Analysis
Managers often consider meta-models to improve their understanding of the absolute and
relative potential of an economic environment. Popular indices include
1. The Global Competitiveness Index (GCI). The GCI summarizes the performance
and relationship among 110 variables that compose 12 so-called “pillars of
competitiveness” within a nation. These pillars tap dimensions like financial market
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development, macroeconomic environment, technological readiness, market
efficiency, and innovation.
2. The Global Innovation Index (GII). Rather than focus on the scale of research
and development, the GII estimates a nation’s capacity to imagine ideas, leverage
them into pioneering products, and, in the process, generate knowledge,
competitiveness, and wealth.
3. The World Competitiveness Index (WCI). The World Competitiveness Project
assesses a nation’s ability to set and sustain a business environment that enables
enterprises to compete, prosper, and create wealth. Four factors determine a nation’s
competitiveness: economic performance, government efficiency, business
efficiency, and infrastructure.
4. The Where-To-Be-Born Index (WTBBI). The WTBBI holds that how well a
country provides opportunities for a healthy, safe, and prosperous life helps explain
both its current and future economic environment. The WTBBI evaluates 11
indicators, such as geography, demography, quality of life, per capita income, and
life expectancy.
B. Economic Freedom, Innovation, and Competitiveness
Economic freedom has a strong relationship with a country’s relative competitiveness and
innovation performance. Table 4.9 indicates that countries with higher degrees of economic
freedom consistently show higher degrees of competitiveness and innovation. [see Table
4.9.]
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